Expatriation from the United States: The Exit Tax.

• Author: Forster, Gary

Abandonment of U.S. citizenship or long-term residency (by non-citizens) may trigger U.S. income tax. The "expatriation tax" consists of two components: the "exit tax" and the "inheritance tax." Both may be triggered upon abandonment of citizenship or (for non-citizens) abandonment of a green card by a long-term resident. In this first of our two-part series, we explain some of the principal terms of the exit tax.

Tax Expatriation Generally

U.S. citizens may expatriate by renouncing their U.S. nationality at a U.S. embassy or consulate. (1) The consul files a certificate of loss of nationality with the U.S. State Department. The effective date of expatriation is the date of renunciation of citizenship.

Long-term (non-citizen) residents (2) may similarly terminate residency for federal income tax purposes upon formal relinquishment of the resident's green card. The residency termination date for a green-card holder is the first day (the then non-resident alien (NRA)) is no longer a lawful permanent resident. (3)

Section 877

Section 877 was added to the Internal Revenue Code in 1966 and, although revised (1996/2004), remains the principal legal structure for the expatriation tax. Section 877 treats an expatriate as a U.S. resident for U.S. income, estate, gift, and generation-skipping tax purposes for any calendar year during the 10-year period following expatriation (before June 18, 2008), if present in the U.S. for more than 30 days. (4) Thus, although expatriation may have occurred in (for example) 2008, [section]877 characterizes a former resident as a U.S. resident for tax purposes for any year between 2008 and 2018, during which the former resident is physically present in the U.S. for more than 30 days.

If an expatriate is subject to [section]877, but not physically present in the U.S. for more than 30 days, he or she is potentially subject to an alternative tax regime. The alternative regime covers the 10-year period following the close of the taxable year in which 1) he or she expatriated, and 2) is not physically present in the U.S. for more than 30 days. Under [section]877, the term "alternative tax regime" subjects the covered expatriate to tax on U.S.-source income at rates applicable to U.S. citizens for a period of 10 years following the date of expatriation, and only if the alternative tax regime produces a higher tax liability than would have been imposed (on the non-resident alien) under [section]871 of the code. Therefore, two tax calculations are necessary to determine which calculation produces the higher tax liability. The income tax liability (calculated under [section]871 of the code, which is the income tax scheme applicable to non-resident aliens under normal circumstances) is compared to the tax liability calculated under [section]877(b) and (d) (the alternative tax regime). The covered expatriate is subject to the higher tax liability.

The principal income tax effect of [section]877 is to impose income tax on U.S.- source income that is otherwise tax-exempt in the hands of a non-resident alien. For example, the covered expatriate may not avoid income tax on 1) bank account interest, 2) portfolio interest, or 3) capital gains earned from trading in U.S. stocks and bonds (generally avoided by NRAs).

The Exit Tax Under [section]877A

The Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act) added [section]877A, effective for individuals who expatriate on or after June 17, 2008. Section 877A(a) imposes a "mark-to-market" tax regime on "covered expatriates." Under [section]877A(a)(1), all property of a covered expatriate is treated as being sold on the day before his or her expatriation date for its fair market value. (5) The exit tax is an income tax on 1) unrealized gain from a deemed sale of worldwide assets on the day prior to expatriation; and 2) the deemed distribution of IRAs, 529 plans, and health savings accounts (taxed at ordinary income rates).

A covered expatriate is deemed to have sold any interest in property held worldwide, other than property described in [section]877A(c) (deferred compensation, specified tax-deferred accounts, and interest in a nongrantor trust (discussed below)), as of the day before expatriation. (6) The property subject to the mark-to-market regime of [section]877A(a) is of a type whose value would be includible in the value of a decedent's U.S. gross taxable estate (on the day before expatriation). (7)

The mark-to-market regime imposes an income tax on the unrealized gain (on the covered expatriate's worldwide assets), but only to the extent the deemed gain (as of the day before the expatriation date) exceeds an inflation adjusted safe harbor ($737,000 for 2020). (8) The rates of tax differ with the type of asset involved. Long-term capital gain assets and qualified dividends receive the applicable preferential rates. However, the unrealized gain in a life insurance...